The absolute decline in the value of the
endowment reflects the return earned on invested assets (essentially nil); minus the distribution of endowment
funds to support University operations and for other purposes (perhaps $1.5
billion in fiscal 2012); plus
endowment gifts received during the year. (Exact sums for investment returns,
endowment distributions, and gifts will be disclosed in the University’s annual
financial report, to be published in mid to late October.)

Seen in this light, the value of the endowment is
of fundamental importance for Harvard’s finances. Endowment distributions
account for roughly one-third of University revenue (nearly 38 percent in
fiscal 2011, according to that year’s annual financial report). To
maintain purchasing power, HMC’s investment professionals aim for a long-term
annualized rate of return of approximately 8 percent, so the endowment
appreciates even after a normalized 4.5 percent to 5 percent distribution rate.
Although the endowment has now recovered somewhat from its post-crisis low of
$26.o billion at the end of fiscal 2009, it remains significantly below the
record $36.9 billion reported at the end of fiscal 2008—and must support a
larger physical plant, much-expanded financial aid, and other costs. Those are
the considerations weighing on the Corporation as it sets future distributions
(at a time when the level of future federal support for research is uncertain,
and families’ abilities to pay higher tuition bills remain under severe
pressure)—and as the administration continues planning
for a large fundraising campaign, likely to be unveiled next autumn.

The
first five months of the year were characterized by a sharp downward correction
in the public equity markets, driven by the U.S. debt-ceiling debate, stress in
the euro zone, and fears of a slowdown in the Chinese economy. Although not as
disorderly, there were some moments involving negative returns and high
correlations among asset classes that were reminiscent of the summer-fall of
2008.

By early
fall 2011 the impact was significant—the S&P [500 equity index] was down
nearly 20 percent, European stocks were down 30 percent, and natural gas was
down 25 percent. As fall changed to winter the world equity markets shook off
their anxiety and recovered nicely, however market sentiment turned sharply
negative once again in the spring.

Public
equities. The
divergent results were particularly pronounced in public stock
investments—about one-third of HMC’s endowment assets, roughly equally divided
among three classes: domestic; developed foreign markets; and emerging foreign
markets.

As a whole, public equity returns were -6.66
percent, or 2.39 percentage points better than the market benchmark.

Private
equity. Private-equity and venture-capitalinvestments (roughly 13 percent of the
portfolio) yielded a 1.99 percent return, trailing their benchmark by more than
2 percentage points. In recent years, HMC has been more cautious about
private-equity investments, reflecting both increased competition for such
assets (and therefore declining returns) and the illiquidity they entail. Now,
however, there are indications that the investment managers see some emerging
opportunities, and are aiming to increase the policy-portfolio weighting by a
couple of percentage points over the next several years.

Absolute
return. Absolute-return assets (a category in which HMC
includes both hedge funds and a smaller portfolio of high-yield fixed-income
investments, together accounting for about one-sixth of endowment investments)
produced a nominally positive return (0.81 percent), nearly 2 percentage points
better than the negative returns for the market benchmarks in this segment.

Real
assets. HMC continues to emphasize investments in real
estate, natural resources (owned assets such as timberland and farmland), and
publicly traded commodities such as oil, natural gas, agricultural commodities,
minerals, and so on—nearly one-quarter of the total policy portfolio. An early
proponent of natural-resources investments, Mendillo
emphasized their appeal in a recent Bloomberg interview. The
theory, discussed in the HMC report, is that such assets produce goods that are
in increasing demand for which it is difficult to increase supply quickly, and
that successful natural-resources investing requires staff expertise of the
sort the management company has built.

Within the real assets category as a whole (where
returns of 3.23 percent more than doubled benchmark results), real-estate
investments were the strongest performer, returning nearly 8 percent and
exceeding market returns. Natural resources returns were positive, at 2.40
percent, ahead of the benchmark. Publicly traded commodities lagged at -8.14
percent, but were better than the even-larger market losses.

Mendillo’s comments suggest further increasing
HMC’s policy-portfolio exposure to natural resources in coming years, perhaps
by a few more percentage points. That increased allocation, and the possible
private-equity commitments, would be accommodated by reduced emphasis on absolute-return
and fixed-income investments.

A “Stabilized” HMC

Compared to prior years’ reports, in which
Mendillo described significant changes in HMC’s staffing, risk management, and
devotion to increased liquidity, the fiscal 2012 report suggests that most such
transition issues are in the past. “Our company and our portfolio have
stabilized and strengthened from their post-financial-crisis state,” she wrote.
“Regarding the HMC organization, with a few near-term planned additions to our
internal equities team, we anticipate being fully staffed on both the
investment and support sides for the first time in several years.”

HMC remains a hybrid organization, with perhaps
two-thirds of assets managed externally and one-third in-house, but it
continues to shift more funds to internal management as opportunities and staff
skills warrant.

She further noted, “We have made good progress on
rebalancing the mix of liquid and illiquid assets in our portfolio, although we
are not quite where we want to be yet.” Obligations to provide future funding
to outside managers—so-called capital commitments—apparently continue to
decline, from the peak level of $11 billion at the end of fiscal 2008 and about
$5 billion in fiscal 2012 to a somewhat lower level now, creating more
flexibility. Despite the volatile financial markets, Mendillo wrote, “[W]ith
our improved liquidity we have been active investors throughout the year in
both liquid and illiquid markets.” As a result, “We were…encouraged by the
breadth of new investment opportunities we found through both internal and
external managers during the year. We have invested in the best of these
opportunities to enhance the positioning and balance of the overall portfolio
and sow the seeds for future growth….”

Continued Caution

Realizing those anticipated returns, of course,
may be a choppy business. The external economic environment and political
uncertainties (ranging from the continuing European debt crisis to China’s leadership
transition and the impending “fiscal cliff” after the U.S. election) continue
to make for volatile markets—from which long-term opportunities may arise.

As Mendillo concluded her report:

This is
a time of unusual turbulence with significant macroeconomic issues facing regions
around the world. While future returns may be uncertain, our strategy is to
remain well diversified and focused on long-term value creation.